Simple Example: Let’s say we go out and I buy you a cup of coffee for $1.00. We agree that the next time we meet, you will return the favor. We sign contracts and everything:)

This is in essence a derivative contract. I bought a future cup of coffee today for a dollar and you agreed to give it to me at any time in the future. If we don’t see each other for five years, or the price of coffee sky-rockets, I will make out quite well! If however, coffee is available out of a tap for next to nothing, I lost my dollar.

Derivatives are just a bet that something will be worth more or less at some point in the future.

The only difference between my coffee example and real derivatives is complexity. There are thousands of different kinds of derivatives that are managed, for the most part, by computers because of their complexity.

There are Different Types of Derivatives

There are two basic types of derivatives, option contracts and forward contracts. These can either be traded on an exchange, or privately. The private ones are the ones that currently have everyone upset!

An option gives the buyer the right, but not the obligation, to buy or sell something at a predefined price, until a specific date. This option normally costs a fraction of the cost of the asset.

A forward contract (Future / Swap) forces the buyer and seller to make a trade on a specific date in the future, and at a set price.

Why are Derivative’s Needed?

They take a lot of risk out of doing business, by spreading that risk to many other people, for a fee. Business’s in this country would be very unstable if they weren’t allowed to stabilize their raw material and currency risks.

Look at South West Airlines as an example. South West, during the period when gas cost $4 a gallon, saw their profits sore because they had established derivative’s that allowed them to buy fuel for $50 a barrel.

Without those derivatives they would have been in the same shape as many other airlines. That definitely would have cost them a loss in profits, but also a loss in jobs.

Derivatives exist for one reason. They are the cheapest way for a company to protect themselves from normally unforeseen risks.

Why are Derivative’s Potentially Dangerous?

You have probably heard the word leverage? Leverage can multiply losses or gains quite substantially. Remember, when you enter into a derivative agreement, you pay a fraction of what the asset costs.

Also, the asset is normally purchased and then sold to the counter party at nearly the same time. Let’s use South West as an example again:

They bought the option to purchase barrels of fuel at $50 when those same barrels were worth about $35. Sounds stupid right? Wrong!

They paid a $1 or $2, per barrel for that option

The counter party didn’t buy the barrels and store them for $35 a piece. (Oil Rots)

On June 2008, oil now costs $125 a barrel.

South Wests counter party is now on the hook for buying those barrels of oil for $125 and then selling them for only $50 ($75 Loss per barrel for a measly couple bucks)

South West got a return of 37.5 times, not percent!

Their counter party lost 37.5 times more!!!

That’s leverage! The chance that you can lose considerably more than you ever invested, or made from the original investment.

Options + Margin = Extreme Danger!

What makes derivatives even more dangerous, is when these contracts are purchased on margin. When you purchase something on margin you are buying it with loaned money.

Because currency movements are so slight, being fractions of a penny. To increase the return on those pennies traders might put up $10,000 as collateral in exchange for $100,000 to invest with. Now if the currency increases by a penny, they made a dime instead.

The problem lies in what happens when prices unexpectedly drop dramatically. Then the guy comes back looking for a repayment of the loan (margin call). Now instead of losing $10,000, you lost $100,000, plus interest!

What are Investment Firm’s Accused of?

Major investment firms are accused of selling derivative contracts that they knew would fail. Kind of like taking out an insurance policy, right before you kill someone.

They supposedly created mortgage backed security pools, that they designed to fail and then bought insurance that would pay out if the mortgages failed. They did and the insurance contracts paid out. That’s why AIG went bankrupt. They were the biggest seller of these insurance products.

That’s All Folk’s

I enjoyed stepping out of the web world for an article. If you liked this article, tell me and I’ll write some more. I was a broker for one of the big investment houses and I can get as technical as you want.

This is all for educational purposes. I do not give advice, nor will I. If you want me to explain the theory behind options, chart patterns, covarience analysis (Big Word!) I’d be happy to oblige.

Here to Serve

Think Tank

35 Responses to “What are Swaps & Derivatives”

The only real difference between a derivative and a swap is that you are obligated to buy with a swap. I could explain option trading in detail, if that is what your looking for? I was a broker when the market fell every day, so I had to learn how to make money in a falling market. If you want more detail on this subject just ask. I wasn’t certain the demand existed. Thanks

Great Summary!!!
I found this article very interesting, and easy to understand for a person without formal financial education.
I don’t see how you can loose more money than you invested in currency trading, you have margin requirements and margin calls that avoid these catastrophic events from happening.

I agree that that would be so for regular investors. As we saw with the banking crisis, sensible margin requirements were not being enforced. That’s what I was referring to in the article. Thanks for your nice comments 🙂

I’m not sure if I understand your question. Derivative investing is extremely risky, because large loans are normally taken out to maximize the return. These loans are known as leverage. I can’t imagine a school district having anything to do with derivative trading because they could lose much more than they originally invested.

Than you for the information. I am working on my graduate studies research about usefulness of derivatives in risk management and want to know more about it. There was an article I have read that Derivatives could result to big losses.

Derivatives are extremely useful, but to invest properly with them requires a pretty deep understanding of statistics and chart pattern analysis. Even with that knowledge they can be quite volatile if not monitored constantly.

The market has changed dramatically because of high speed trading. Why this is important is because in the past a normal trader would be able to see what was coming and react accordingly. Now regular investors have to weight minutes to receive information that other react to in milliseconds.

I wish u could explain it in a more simplified way…coz i am very new for understanding the economic jargons…that u used in some of the part so to mention..so plz can u elaborate in a simplified manner..?

Found that extremely useful, although i still require further research but this has set me in the right direction. sending my love from the UK. thank you. I’ll be awaiting any further material you release. 🙂 thanks again mate

This was very useful for me, as I have quite an interest in finance but no real in-depth knowledge thereof. One thing, however: all throughout the tutorial you plualize nouns by adding an apostrophe (derivative-derivative’s, option-option’s, etc.), an error noticeable enough to distract one from fully absorbing the otherwise very informative content. You need only to add an s at the end of a noun such as derivative to make derivatives. No additional punctuation needed.

Yes I used to mess up grammar in the past. It was a by product of forcing myself to write an article or make a video each and every day. I used to just spell check and upload. Sorry about the distraction

Thank you 🙂 Derivatives are no where near as complicated as people say. That is not to say that they can’t become complicated when used in concert with many others though. I’ve always wanted to cover this topic in depth some day. Who knows I may get to it soon?

Every investment carries risk. To limit it you need to diversify. For example if you have a bunch of Hershey stock and you notice that when the price of Hersheys goes down the cost of sugar goes up you buy some sugar to offset that risk.

The information you are looking for is called Covariance Analysis. I talk about it in this article and in a few others on my site.

Thank you 🙂 Personally I can’t advise people on how to invest since this is a very dangerous course of action especially today. I personally have found it to be much more profitable to invest in my own businesses and with local business owners.